Threat to corporate governance as compliance improves

More than 61.2% of FTSE 350 companies now comply in full with the UK Corporate Governance Code. But Simon Lowe, chair of the Grant Thornton Governance Institute, is concerned that this improvement hides an undermining of the very principles the Code is based on.

Overall, it’s been a year of change in the governance landscape. The 2013 Directors’ Remuneration Report Regulations sought to make reporting on pay more transparent and sparked a number of high-profile shareholder revolts on remuneration policy. The EU legislated to cap bankers’ bonuses and passed regulations to introduce mandatory rotation of audit firms and limit their provision of other services. Further scandals in the banking sector prompted lively public debate about conduct and the role of regulation. Meanwhile, the introduction of the 2013 Strategic Report and Directors’ Report Regulations heralded significant changes to the style and content of annual report narrative and non-financial information. The increased requirements for audit committee and auditor reporting brought greater transparency into their respective work and focus.

FTSE 350 Corporate Governance Review 2014

To reflect this continued evolution, we have altered the structure of this year’s Corporate Governance Review. to mirror the structure of a FTSE 350 annual report, organising our analysis under the headings of the Strategic report, Governance, Nomination committee, Audit committee, and Remuneration committee. We've also included some comparative information from the US to highlight the differing practices on board composition.

New strategic report – has it worked?

We hoped this year’s introduction of the strategic report would enhance the clarity and relevance of reporting for shareholders. In practice, the standard is very mixed.

There are a few excellent examples, where companies clearly gave serious thought to the report’s purpose, what information to include and how best to present it. However, many organisations simply grouped their former financial, operational and CSR reports under a single section making little effort to integrate the information.

The fact that many companies make basic errors in presenting the information required, suggests a lack of commitment and buy-in to the objective of the report. Further, while companies were comfortable talking about past performance (77%) only 60% were able to clearly articulate their business models and when it came to looking forward this sank to 43%.

We are concerned that something that was intended to improve reporting quality is being undermined by this mechanistic approach, which throws into question the FTSE 350’s commitment to effective governance.

Compliance gathers pace but threatens UK governance principles

By contrast, there is a clear focus on governance in other areas. The number of companies choosing to comply in full with the Code increased again, from 57% last year to 61%. Yet this may not be all good news.

It is worth considering if the goal of full compliance is desirable, as each company’s circumstance will be different and the purpose of ‘comply or explain’ is to give companies the flexibility to reflect this when in the interest of the shareholders. What is worrying is the anecdotal stories I hear of the rising influence of the proxy voters and the need to be ‘seen’ to fully comply – when not doing so can lead to red tops and negative voting.

Are we getting to the stage now where the need to demonstrate full compliance is actually overriding the principle of ‘comply or explain’, pushing us towards a regulatory-based system? It’s rather ironic when you consider that after many years of doubt, Michel Barnier, Vice-President of the European Commission, now agrees that principles are the way forward.

Personal accountability on the rise

The trend in personal accountability from board and committee chairmen that we noted last year has gathered pace. In particular, 93.1% of remuneration chairmen introduced their remuneration report this year, with 84.2%, up from 70% in the previous year, providing a good or detailed outline of the committee’s work and the benefits of the remuneration policy.

We support accountability but this increase also comes with a governance health warning. The annual report is not a substitute for direct consultation with shareholders. Better consultation with investors before the AGM could have avoided this year’s protest votes against remuneration policies. Having now to agree the policy on a three-year cycle might help.

Audit committees seem to be adjusting well to their increased reporting responsibilities. We found that 64.7% produced an effective explanation of the work done in relation to areas of judgment and estimates in the accounts.

Nominations committee lagging behind

However, less insight is forthcoming when companies explain how they go about monitoring the effectiveness of internal controls – here, only 18% show the way.

With such progress in transparency and accountability in both remuneration and audit committees, in the coming year I expect the searchlight now to focus on the nominations committee, which remains adrift in the doldrums. Just 35% of chairs introduce the report and only 13.5% give real insight into how they are responding to their recent board review, while succession planning is rarely discussed.

Plotting a new course

This year’s changes in corporate governance and reporting seek to promote greater transparency about how boards operate, particularly how the balance between short-term performance and long-term sustainability will be maintained.

Our findings show that in many areas companies are still finding their way. However, we are encouraged by the level of debate that recent changes have provoked between boards, investors, auditors and other interested parties. Dialogue between stakeholders is the bedrock of effective governance and we are interested to see whether a consensus emerges over the coming years.